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Whenever any would-be borrower approaches a lender for a loan, he must be prepared to offer collateral, just in case he cannot repay the loan. If he defaults, the lender wants to be able to gain possession of the collateral, and obtain it quickly.
Every government that uses bond sales to maintain its level of expenditures must offer collateral. This collateral is its ability to extract sufficient revenue from those people under its jurisdiction so that it can make interest payments on the bonds.
In the South of 1850, a planter could buy slaves on credit. He pledged the future productivity of his slaves as collateral for the loan. He made sure that he extracted sufficient wealth from the slaves to pay off his loans. He lived well. They didn’t.
Why did he borrow? In order to buy more slaves. He used leverage. He built his plantation with borrowed money and the heirs of kidnapped victims. It was good business.
The typical voter thinks of himself as a free man. After all, he has the right to vote. He does not think of himself as a slave. While trade union organizers — a truly hopeless career these days — still use the phrase “wage slave,” it never made any sense, either legally or economically. A worker can legally walk away from his employer. A slave cannot.
Washington has borrowed more heavily than any planter ever dared to or could do. Why so much debt? To get more leverage today. What is being leveraged? Promises. Voters trade votes for government promises. This system requires an ever-increasing supply of slaves in order to pay the interest on the debt. Problem: the rate of population growth is slowing. There will not be enough slaves to pay off the debt.
Voters have not thought through the implications of government debt. They do not perceive themselves as collateral for loans. But they are. This is the meaning of the phrase, “the full faith and credit of the United States government.”
“FULL FAITH AND CREDIT”
Whenever you hear the phrase, “the full faith and credit of the United States government,” an image should pop into your head: a slave overseer in Alabama 1850, whip in hand, sitting on a horse at the edge of a cotton field. The field is filled with slaves, bent down, fingers scarred, dutifully picking cotton. You are not the overseer. You would be lucky to be his horse.
The public buys government promises to pay future money in exchange for present votes. The trouble is, the promises are backed by the full faith and credit of the United States government. That means the overseer will handle the payment system.
The U.S. government is borrowed short and lent long. To understand this arrangement, you must understand the currency. The Treasury borrows money on average for about five years. (http://bit.ly/USdebtMaturity) It spends this money to meet its obligations. These are political obligations. The politicians bought past votes with promises of future payments. Today’s expenditures are these payments, which come due day by day. The government must borrow about $1.3 trillion a year to make good on past promises. This is in addition to $2.5 trillion in tax revenues.
Candidates for office continue to make new promises to voters. The benefits of votes accrue to the elected candidates when they take the oath of office. The costs are postponed. The price of votes keeps rising. The politicians promise to make even larger future payments.
The federal government is borrowed medium-term in the credit markets: a five-year rollover of the debt. It needs cash to pay off past promises. So, it borrows long: promises to pay far more money over the next 75 years: Medicare and Social Security.
This is a Ponzi scheme.
Why do voters consent to this? Because they, like the planter in Alabama in 1850, think this system can go on forever. But there is this crucial difference. The planter never worked in the fields. The voters do.
Voters think of themselves as buying the right to sit on the veranda and sip mint juleps in their old age. Those who got into the Ponzi scheme early did just this. Ida Fuller is the classic example: $24 paid in, $23,000 pulled out. But most voters will spend most of their days in the fields. There will be no mint juleps for them.
“WE OWE IT TO OURSELVES!”
This one became popular in the New Deal in the mid-1930s. It was still popular in the 1950s. We do not hear it as often these days, which is a good thing.
We need a mental image for this, too. There is a crowd in front of a large domed building. There is a much larger crowd behind it. Members in the crowd in front have gray hair, white hair, and no hair. They are all sitting in battery-powered carts. There is a large sign in the middle of the crowd: “Ourselves.” The people lined up at the back door also are marked by a large sign: “We.” Everyone has his wallet open. The people in front of the building have the money slots facing up. The people at the rear have the money slots facing down. On the domed building, there is a sign: “Promises R Us.”
The implications of the credit/debt relationship are not understood well by voters. The system is based on differences in time. Voters see themselves as spending their golden years in one of those battery-powered carts. They believe that if they pay for a ticket to a cart through their working years, they will get their carts. They lend long (working years) in order to receive the fruits of their investment (retirement).
To facilitate this, the federal government issues tens of millions of dated tickets: “Good for a free cart and all that goes with it.” But the ticket refers the holder to a web page. There, in obtuse legal language, we find a qualification: “Subject to revision by the issuer.” This means that the date on the ticket can be changed. A wheeled walker can be substituted for a cart. A cane can be substituted for a walker. Finally, a card that says “Think Vertically!” can be substituted for a cane.
“I OWE YOU SOMETHING”
An IOU is a promise to pay. The value of this IOU depends on four factors: (1) the solvency of the borrower, (2) the expected future value of the asset promised, (3) the length of time before the IOU comes due, and (4) the current interest rate for a loan of that maturity. Through competition, a price is set by the market.
A government-issued IOU is different from a legal contract between private parties. A debtor government is the enforcer of the loan. It can therefore change the terms of the loan at any time. So, the public must have great trust in the government. Voters must assume that the government’s word is law. They are correct: it is law. This is the problem. The law can be changed at any time by a new crop of politicians.
With respect to solvency, the U.S. government is assumed to be the most solvent borrower on earth. The U.S. dollar is the world’s reserve currency for central banks. The U.S. Treasury today pays about one one-hundredth of a percent for 90-day IOUs. There is nothing else like this anywhere. There has been nothing like it ever since the Great Depression.
Yet the level of federal debt is growing rapidly: by $1.3 trillion a year in the on-budget world, and even faster with respect to unfunded Medicare and Social Security debt. The vast majority of economists insist that the United States can and will grow its way out of these obligations. This means that the government’s collateral — you and I — will increase our productivity and also consent to have at least 25% of it removed by federal taxes.
Federal solvency will not be maintained for another decade. The numbers point to a default. But investors do not care. Every large nation’s solvency looks equally bad or worse. By comparison, the dollar is the one-eyed man in the world of the blind.
The other national governments are running huge deficits that are also unsustainable. Because the politicians of every large nation sell promises for votes, the international exchange rate of the dollar is holding up. The liars in other nations indulge in the same exchange. Their lies are no more believable than ours, and maybe less.
What about the market value of the asset designated by the IOUs? What about the long-term purchasing power of the U.S. dollar? Today, price inflation is low. Lenders assume that they can sell the government’s IOUs if this low rate starts up. This assumes that most investors will sell their bonds in time. Sell to whom? At what price?
The dollar will fall in value because the Federal Reserve will inflate. But this question confounds investors: lower compared to what? Gold, euros, yen? Real estate? What? When? How fast? How soon?
The IOUs of the world are based on digital currencies manipulated by central banks. The dollar looks good in the future because of how bad the other currencies look. The Federal Reserve is trusted by investors.
The longer term the IOU, the more opportunities for default, inflation, and new legislation to destroy investors’ hopes. This is why 30-year bonds are risky. But with the FED twisting — buying long-term bonds and selling short-term bills — the low long rates on T-bonds can be maintained for years. People say that there will soon be a popped bubble in 30-year T-bonds. This threat always exists. If commercial banks start lending to the public again, thereby converting the FED’s more than doubled monetary base into M1, the money multiplier will increase. So will prices. But this has not happened. There are few signs that it will happen in 2012. So, twisting keeps T-bond rates low. Also low are Fannie/Freddie mortgage rates.
So, the U.S. government’s IOU-something still has a strong market. It owes U.S. dollars, which are in high demand as the euro moves towards the precipice. The Treasury is in the catbird seat. It can sell its IOUs at historic low rates.
Residents in any nation are collateral for various government’s loans. The politicians have pledged a substantial portion of the taxpayers’ future productivity.
But there is a problem facing lenders: this collateral votes. Collateral for all loans except loans to a government is inanimate. It can be collected by the lender after the debtor’s default. This is not true of human beings. They cannot be transferred to the lenders after the bankruptcy.
This is why it is not possible for a private lender to collect payment from a civil government that decides it will not pay. The lender is left with a dead IOU: “You should have read the fine print, dummy.” The fine print says that civil governments are sovereign. They pay their debts at their discretion.
When voters at long last recognize that the promises made by the government have become too expensive to fulfill, voters will send this message to Washington: “Stop payment.” It will take several election cycles to elect enough politicians who will be in a position to issue a “stop payment” notice to the Treasury, but it can be done. More than this: it will be done. The escalation of the debt is so rapid as to make “Stop payment” inescapable.
The political battles after the election of 2016 will focus on which departments will receive the “insufficient funds” memo. If the answer is “none,” then the political question will be this: “How high a rate of price inflation will the voters tolerate?”
At some point, voters abandon a hyperinflationary currency. They refuse to offer goods and services in exchange for the currency. The currency falls to zero value. This is what Ludwig von Mises called the crack-up boom. After it ends, a new currency is declared by the government.
Note: there have been few such crack-up booms in modern history. Most came after the loss of a major war. Here is a crucial fact: the replacement currencies were fiat currencies. No government ever since 1914 has gone from a crack-up boom to a precious metal currency. Every government has inflated again. The citizens have never insisted on a gold standard of any kind, let alone a gold coin standard in which the government shuts down both the mint and the central bank. Not even Andrew Jackson did this.
This is political reality. We hear of a supposed reform by some national government to introduce some variety of fractionally reserved, non-redeemable gold standard. I pay no attention to these rumors. First, central bankers are not Austrian School economists. Second, without full redeemability in gold coins, any gold standard is a promise-based standard, a pseudo-gold standard. It is a counterfeit. It is just one more political promise. Political promises have gotten us into the present mess. They will not get us out.
Until there is a free market-based gold coin standard and also the abolition of the central bank, voters have not escaped from their status as collateral. For as long as there is a market for government bonds, taxpayers are still collateral. They reserve the right to unilaterally remove themselves from full liability. When it comes to debt, a government is a limited-liability organization. It can default on all or a part of its debt. That is what the U.S. government will do: declare a partial default. The longer the government runs $1.3 trillion annual deficits, the more extensive the default will be.
There is another possibility, rarely discussed. The Federal Reserve can stop buying Federal debt. If the FED ever decides, as it did under Paul Volcker’s early years, late 1979 to mid-1982, to cease buying Treasury debt, that would be the equivalent of “Stop payment.” Why? Because the FED would cease to supply the money necessary to make the otherwise unfunded payments. The Treasury would have to sell its debt to private citizens or other central banks. That would mean rising interest rates and broken promises.
All debt must have some sort of collateral. If voters understood that they are the collateral for the federal government’s debt, they might rebel. They might demand a total default. But I don’t think this is likely. The vast majority believe that they will be the folks sitting on the veranda sipping mint juleps.
I would like to think that Ron Paul is Moses, calling the slaves to resist. But I recall their reaction.
And the officers of the children of Israel did see that they were in evil case, after it was said, Ye shall not [di]minish ought from your bricks of your daily task. And they met Moses and Aaron, who stood in the way, as they came forth from Pharaoh: And they said unto them, The LORD look upon you, and judge; because ye have made our savour to be abhorred in the eyes of Pharaoh, and in the eyes of his servants, to put a sword in their hand to slay us (Exodus 5:19-21).
December 31, 2011
Copyright © 2011 Gary North